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The 'cynics' are underestimating the power of central banks

Nikolaj Schmidt

28 October 2019

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There currently seems to be a lot of cynicism about the power of central banks to influence global growth. A growing number of people appear to believe rate cuts are no longer as effective as they once were, and central banks are therefore effectively impotent. I disagree.

Why? Well, it is important to understand the context. For more than a decade, global growth has been suppressed by deleveraging of one kind or another. By deleveraging, I mean reducing the pace of credit growth to the level of nominal gross domestic product growth, rather than reducing the overall level of credit outstanding.

The deleveraging has come in four phases - the global financial crisis, the eurozone crisis, the taper tantrum and the current wave of Chinese deleveraging. These phases of deleveraging have applied a series of powerful brakes on the global economy, one after another, over the past 11 years. As yet, there has not been any meaningful re-leveraging of the real economy to counteract this.

In addition, the global economy has had to contend with a series of uncertainty shocks over the past few years - such as Brexit, the rise of populism and trade wars. This has made it harder for consumers and businesses to make confident predictions about the future, which has hit growth through a reduction in capex.

Faced with these powerful headwinds, it is hardly surprising that central bank rate cuts have had less of an impact on growth than we would usually expect. However, this does not mean rate cuts have become inherently less effective - rather, they have not appeared as potent as in the past because of the context in which they have been administered.

I believe central bank rate cuts can still be very effective and the current phase of easing has the potential to offer much stronger support to the global economy than the cynics believe. In my view, consensus opinion underestimates the amount of global monetary accommodation that has been administered: US 10-year yields have fallen by about 180bps, German 10-year yields have dropped by approximately 130bps and the 30-year Japanese benchmark rate has fallen by circa 55bps.

This shows we are living through a phase of a very substantial and synchronised - though uncoordinated - easing of global monetary conditions. In addition, according to our internal models, we are at the precipice of a positive response from the interest rate-sensitive components of demand - such as in autos and housing.

The easing of monetary and financial conditions works with a lag. The absence of a response to date does not mean monetary policy has stopped working, though it may seem this way to some. In the absence of any new shocks that create more uncertainty, I believe we are close to an inflection point in growth at which the transmission of easy financial conditions will kick in and spending on durable goods and capex will follow.

This should help to keep a recession at bay for a while yet - possibly for up to three years. A recession will arrive at some point, but the next recession is unlikely to be as severe as in 2008. It will probably be milder than in 2001, because the structural imbalances that would cause a major recession simply do not exist today.

When it comes, the next recession likely will be caused by the labour market, which is beginning to look too tight. If the labour market overheats, profits will be squeezed and companies will, consequently, suspend capex and stop hiring. This is how the expansion peters out.

Although the next recession is likely to have less impact on the real economy, it is likely to be painful for financial markets, because companies have ratcheted up debts to undertake cash distribution to shareholders through stock repurchases and dividend payments.Central banks will have less room to manoeuvre when the next recession comes around, but this does not mean they are impotent. Monetary policy is not primarily about the level of interest rates, but rather about directing capital flows to engineer loose financial conditions. In my view, central banks still retain some tools to do this.

Many people were convinced the European Central Bank and the Bank of Japan were running on empty last year, but since then the 10‑year German government bond yield has fallen from about 80bps to ‑50bps and the 30‑year government bond yield in Japan has fallen from about 90bps to 35bps and financial conditions have been loosened substantially. We should be wary of underestimating determined central banks.